HCL Tech: Margin trigger missing

Despite double-digit growth across segments, profitability remains lower than peers.

Till recently, HCL Tech was mostly considered to be a one trick pony. The perception was that the company could manage to grow only one of the three things at a time – margins, revenues or receivables. However, over the last few quarters the management has done its best to dispel this theory. Over the last three years, HCL Tech’s consolidated revenues clocked compounded annual growth rate of 24 per cent. Over two years, the customer count across buckets doubled and employee base grew at a CAGR of 14.9 per cent over three years. For the financial year ended June 30, the company’s revenues grew 31.1 per cent year-on-year to $3.54 billion, while net income grew 35 per cent to $378 million. While cash flow conversion is becoming an issue for rivals, HCL’s cash flow conversion (ratio of cash flow from operations to net income) stands at 100 per cent backed by efficient working capital management.

HCL’s performance stands out in FY11 due to its broad-based growth across service offerings. In the fourth quarter, infrastructure services (transformational business) and custom applications services (traditional) annually grew 44.7 per cent and 37.9 per cent, respectively. The market is kicked about this segment as this is the future of IT services, as the days of low-end work is over. In fact the manner in which the company has built vertical expertise, the Street is comparing it with Cognizant.

Despite such a good show, the stock fails to command the premium its peers do. HCL’s stock trades at 15x its FY13 earnings, while Infosys trades at 19x and TCS at 20x. So where’s the catch? Analysts believe that despite playing catch up over the last few years, the company is still not able to improve operating margins (Ebit level), which stood at 14 per cent for FY11 and 15.5 per cent for Q4FY11. Compare this with Wipro’s Q1FY12 Ebit margin at 21 per cent, Infosys' at 26.1 per cent and TCS' at 26.2 per cent. Analysts were hoping to hear some talk on margin growth, but Vineet Nayyar, CEO of HCL Tech, ruled out such a possibility in FY12. Abhishek Shindadkar, IT analyst at ICICI Securities, says: “A lot of people would have liked to hear the company say it was planning to take margins to 15-16 per cent levels, which is not impossible. In fact the overall commentary — on margins and pricing — was not optimistic.”